Do active managers outperform in down markets?

The short answer is no.

One of the prime active manager’s pitches against passive investing is that they outperform in bear markets. The argument is that active managers can foresee downturns and position their portfolios accordingly, adding value through better selection into more defensive securities, compared to an index fund manager who must track the benchmark regardless of market direction. There are a few studies that remotely confirm claims that active managers perform better in down markets. Could that really be due to their superior stock selection abilities? Of course not, we already know that the market is a zero-sum game and for every outperforming active participant there has to be an equally underperforming active participant. Or every portfolio manager overweighting defensive stocks, there has to be one overweighting cyclical stocks. Once you add in expenses and the picture looks even less likely. What is going on then? When you look under the hood, the answer becomes apparent:

  1. Cash positions help active managers limit losses. Open-end fund hold significantly more cash to service redemptions and have the necessary liquidity. According to Morningstar the average US Large Cap fund holds nearly 3.5% cash position, while the equivalent S&P 500 ETF holds less than 0.3% and the plain benchmark holds zero cash. In down markets, this more than 3% difference will provide the appearance that a bigger percentage of active managers are beating the index. It also explains why in bull markets passive vehicles look so much better.
  2. Measurement errors by using an inappropriate benchmark. If active managers portfolios include securities outside the index, for example, small caps exposure which has outperformed the S&P 500 can give the appearance that active managers are beating passive S&P 500 vehicles.
  3. Not all active managers are included in the data. When such statistics are taken they often include only mutual funds and exclude the rest of the active managers in the market. For example hedge funds, institutions, individual investors, and other active participants in the market are excluded from the calculation painting only a partial picture.

It is mathematically impossible for the average active participant to outperform the market. Nevertheless, the media and the less informed investors commonly believe such fallacies.  

On top of that, even the studies such as the Vanguard summary table below show mixed results. Considering all the measurement errors, both US and European active mutual funds still underperformed in bear markets. If one wants to limit downside, their goal should be to diversify not assume that just because they use active funds, their downside will be limited.



1 thought on “Do active managers outperform in down markets?

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